The long-term benefits of tax reform will be many. A lot of investors have become as hooked on our distorted tax code as an addict on heroin, undertaking unproductive investments solely for tax benefits. Lower tax rates and fewer tax shelters will provide a better basis for economic decisions, and will bring more growth and a healthier economy. However, many analysts are misreading the short-term effects of shifting "cold-turkey" from a high-rate-shelter-rich tax regime to a low-rate-shelter-poor tax regime--effects I believe will be sharply deflationary.

To most economists, lower tax rates will put more cash in consumers' jeans, which they will use to buy more goods, thus stimulating the economy. To them, lower tax rates mean more growth and the danger of renewed inflation, so the appropriate Federal Reserve policy is to tighten credit conditions to offset the tax-cut stimulus. And the appropriate investment strategy is to sell bonds, which are losers when interest rates rise, and to increase holdings of growth-sensitive stocks, to take advantage of the growth in profits that accompanies a strong economy.

The positive effects of lower taxes on spending and labor supply initially will be swept aside by the deflationary effects of tax reform on the asset markets. Years of high tax rates and liberal deductions for "tax advantaged" investments have caused investors to build up an array of investments, such as shopping centers and office buildings, which would otherwise not have been made.

More Money Will Be Needed

All of these shelters require the investor to take physical ownership of some tangible asset, and to be responsible for the debt that was incurred to purchase the asset. Lower tax rates and fewer shelters will hit the asset markets like a further reduction of inflation, by destroying the reasons for owning hard assets and triggering a massive switch of investors' asset demands away from oil. gas, real estate and other sheltered assets, and toward bonds, stocks, money-market investments and other producers of taxable income. The resulting attempts by investors to disgorge their holdings of tangible assets will unleash a wave of deflation much like the one we've been living through, imparting additional damage to the already weakened hard-asset sectors.

When this happens it will be extremely important that the Fed stand ready to print the additional money required to offset the initial deflationary impulse of tax reform. Restructuring has produced a glut of hard assets. That’s why the 13% to 15% money growth of the past two years has not led to the rising inflation that many feared. It has taken higher-than-normal money growth to sop up the tidal wave of office buildings, oil assets, farm land and equipment that were dumped back onto the resale markets by their owners.

When forecasting prices, we need to remember that an existing office building being pushed back onto the market by its current owner will depress property values just as much as the sale of a new one. Undesired assets held by current owners should be added to current GNP when figuring the aggregate supply of goods in the economy. To keep the price level stable the Fed must print the money required to make demand grow fast enough to absorb this total supply of both new and old goods. If the Fed doesn’t, prices will fall.

Stirring tax reform into the pot will mean the Fed will need to tolerate still higher money growth--15% to 20% in both 1987 and l988--to keep the economy’s nose above water. But this increased money growth will not cause inflation. If the Fed falls to deliver the needed stimulus, or worse yet, if it tightens monetary policy, as many economists will be urging, the current relatively minor deflation could snowball and push us back to the 1930s.

Tax reform’s deflationary impact is not caused by the direct effects of lower tax rates on spending, savings and income flows, but by the indirect effects on the economy’s portfolio. Most economists pay little attention to balance-sheet conditions-since the 1930s macroeconomics has focused a/most exclusively on explaining variations in the GNP accounts. I believe this is the reason many forecasters failed to predict the major events of the 1980s. For example, rising budget deficits in the early 1980s led to a consensus view that interest rates would rise. Instead, they fell sharply, even as deficits rose. And rapid money growth after mid-1982 led many analysts to expect rising inflation and higher interest rates, views that led many investors to sell bonds and buy cash and real estate, providing a market for investors who were aware of the ongoing repricing and restructuring of balance sheets.

Fluctuations in GNP-just over $4 trillion in 1986-or its components are important because they have a direct bearing on paychecks. But they can’t compare with the shock waves that roll across the country when something big is going on in the country’s $30.9 trillion portfolio of assets, of which $12.5 trillion (41%) were held as tangible assets, like houses, boats and boxcars, and the remaining $18.4 trillion (59%) were held as financial assets, like stocks, bonds and bank accounts. When investors are content to hold existing assets at current prices, the portfolio economy, like a sleeping giant, has a benign influence on the production economy. But a radical change such as tax reform can dramatically change the relative attractiveness of holding tangible and financial assets. When this happens, investor attempts to rebalance their portfolios can unleash hundreds of billions of dollars in transactions that can swamp the influence of more normal flows of funds in setting price levels, interest rates and economic activity. David only beats Goliath in books. In the real world, Goliath wins every time.

In the 1980s, for example, a more than 10-percentage-point drop in the inflation rate led to a sharp deterioration of the return on tangible assets, because price increases were such an important part of asset yields in the 1970s. In addition, the 1981 tax cuts on interest and dividend income made stocks and bonds more attractive. These changes caused investors to attempt to reduce the portions of their portfolios held in tangible assets and increase the portions held in cash, bonds, stocks and other financial assets. Collectively, of course, this could not be done, since the existing stock of assets must always be held by someone. But the attempted portfolio shift played havoc with asset prices. Gold, farm land and other commodity prices plummeted. Fortune 500 companies alone announced the sale of nearly $200 billion of fixed assets in 1985. In total, tangible assets have lost more than $1 trillion in market value since 1981.

Tax reform is taking place while we are already in a deflation. The adjustment of the economy to lower inflation and to the 1981 tax cuts is not yet complete. We are perhaps two-thirds of the way through a 10-year wringing-out, or withdrawal, process, required to wean the economy of its despondence on rising prices. It takes several years just to break people out of their inflation psychology.

While this is going on, capital-goods prices and profit margins are weak--the market’s way of telling rig producers to stop the presses. Disinflation means a glut of certain kinds of capital goods on the resale markets. As long as you can buy capital goods cheaper than you can make them, growth is going to stay weak.

The Fed’s role in this withdrawal process is to deliver methodone treatments. By printing more money the Fed has the power to blunt the deflation symptoms caused by the change in asset demands. Since 1982 I believe it has done a good job in keeping money growth low enough to keep disinflation working, yet high enough to keep deflation from getting out of control. Recent announcements that the Fed has backed away from money targets and will instead stabilize prices is good news. This is no political accident. Last year's 120 bank failures were the highest in any year since 1934. This "bank-failure standard" is the right policy for managing the difficult transition before us, and absolutely crucial in light of tax reform.

Tax reform will severely test the Fed's new policy. Lower tax rates on interest and dividend income will make financial assets even more attractive to hold, and fewer deductions and tighter rules on shelters will make tangible assets less attractive to hold. This will worsen deflation by making corporate managers accelerate restructuring plans by dumping more fixed assets to repay debts and repurchase shares on the stock market. Unless the Fed prints the money to create the demand to take these additional assets off the market, the price level will fall.

Magnification of Effects

We can roughly estimate the amount of money the Fed will have to print in order to offset the deflation that will accompany lower tax rates. A cut in the maximum personal tax rate from 50% to 28% will increase the after-tax return on a one-year bond paying 10% interest from 5% to 7%. This two-percentage-point improvement in financial-asset returns, relative to the returns on sheltered investments, will affect the asset markets about like a two-percentage-point drop of inflation, so the Fed will have to raise money growth by about 2% from this year's level in order to offset the deflationary effects of tax cuts.

But the ongoing disinflation adjustment will magnify the effects and increase the work the Fed must do. Disinflation means falling interest rates, and falling rates mean very large total returns on long-term bonds. In 1985, for example, the 30-year Treasury bond had a total return in excess of 30% for the year. Reducing the tax rate from 50% to 30% means an after-tax return in this case would increase from 15% (half of 30%) to more than 21%. The Fed may have to increase money growth by as much as six percentage points to offset the implied deflation pressures.

Tax reform, with lower rates and fewer shelter gimmicks, is as imperative for the country as purging the dependence on drugs is for a narcotics addict. But we mush not ignore the deflationary withdrawal pains that we experience during the decade-long transition from the high-inflation, high-tax economy of the 1970s to the stable-price, low-tax-rate environment that we have chosen for our future.